Thursday, November 6, 2008

Are We Bubbled Out?

Stocks got clobbered again today, as the Dow sliced right through the 9,000 level, tumbling 443 points to 8,696. Since Obama's victory, stocks have given back 10%:

Major indexes have lost about 10 percent since Barack Obama was elected president -- a vote preceded by a steep rally -- and the losses represent the Dow's worst two-day percentage decline since the October 1987 crash.

Paper losses during that time in U.S. stocks came to $1.2 trillion, according to the Dow Jones Wilshire 5000 Composite Index, which represents nearly all stocks traded in America.

Comments from Cisco that it saw a steep drop in orders in October and reports from retailers that consumers are skipping trips to the mall provided fresh evidence of the economy's struggles. Worries about automakers and the financial sector compounded investors' unease.

A day ahead of Friday's key October employment report, a widely watched barometer of the economy's health, the Labor Department said the number of people continuing to draw unemployment benefits jumped to a 25-year high. The increase by 122,000 to 3.84 million in late October marked the highest level since late February 1983, when the economy was being buffeted by a protracted recession.

"The economy is in a pretty significant downturn and I think that is broad-based because it is all interconnected," said Ed Hyland, global investment specialist at J.P. Morgan's Private Bank. "This is something that we haven't really seen, this level of this rapid and significant pullback both in the market and the economy."

But the big story today happened early this morning when the bank of England surprised everyone by slashing their key rate by 150 basis points. The market was expecting a 1% cut and this move smelled like panic.

The euro and the pound declined for a third day after central banks in Europe and the U.K. reduced borrowing costs to counter the worst financial crisis in almost a century.

The 15-nation euro headed for a weekly decline after European Central Bank President Jean-Claude Trichet said policy makers may lower rates further after cutting the main refinancing rate by a half-percentage point yesterday to 3.25 percent. The pound also headed for a weekly decline after the Bank of England slashed its benchmark rate by 1.5 percentage points to 3 percent, the biggest cut since 1992.

``These rate cuts highlight how serious the problems are that Europe and the U.K. are facing,'' said Akio Shimizu, chief manager of foreign-exchange trading in Tokyo at Mitsubishi UFJ Trust & Banking Corp., a unit of Japan's largest publicly listed bank. ``The trend for the euro is to go lower. It may be some time before we see the pound form a bottom.''

As shown above in Bloomberg's chart of the day, this represents the first time that BOE rates fall below the ECB's:

The CHART OF THE DAY compares the two rates after today's reductions. The Bank of England cut its benchmark by 1.5 percentage points to 3 percent, the lowest since 1955, and the ECB pared its key rate for the 15 euro nations by a half-point to 3.25 percent.

``The U.K. is weakening at a more severe pace than Europe,'' said George Buckley, a London-based economist at Deutsche Bank AG. ``The relative rates are appropriate; they reflect the different expectations for the two regions.''

Next year, Britain's economy may shrink 1.3 percent as the global credit squeeze deepens, according to International Monetary Fund forecasts published today. The group expects a contraction of 0.5 percent in the euro area, 0.7 percent in the U.S. and 0.2 percent in Japan.

Trade finance — the grease of the world economy — used to be easy to find. It’s now so expensive that it threatens to halt global commerce. The Baltic Dry Index, a barometer of world trade that measures shipping rates, is down 93 percent from its peak in May to the lowest in nine years. Shippers were the first to be hit by the credit crisis, but importers, who now have to borrow at prohibitive rates, are also feeling the pain.

A year ago, importers might have paid only one percentage point above the London interbank offered rate, known as Libor, to finance trade. Today it’s likely to be around three percentage points over Libor. World demand is slowing, so why is the cost of trade rising?

Demand for letters of credit — the simplest form of trade finance — has skyrocketed. Under these agreements, an importer’s bank extends to an exporter’s bank a credit line that is released once the conditions of the trade are met. This assures the seller — who may not know his counterparty — that he will be paid.

When the economy was buoyant, the seller would collect payment directly from the buyer’s open account when goods were delivered. But recently even buyers and sellers with longstanding relationships have begun to question their counterparties’ health. Traders now want their banks to guarantee each transaction.

But banks are struggling to fulfill their age-old function of financing trade because they no longer trust one another. While interbank lending shows some signs of thawing because governments have stepped into the breach, banks are still wary of taking on counterparty risk from other banks outside of mainstream money markets. Add to this their constrained balance sheets, global currency volatility and more rigorous risk assessment, and it’s not surprising that the cost of trade finance has shot through the roof.

Those who can afford it are paying a steep price to trade. Those who cannot are running down their inventories or trading less. But the longer trade finance remains sclerotic, the larger the threat to the world economy becomes. Corporate defaults could rise, pushing up the cost of doing business even further and dragging trade and the economy down in a vicious circle.

No wonder President-elect Obama is scrambling to meet with his economic advisory group tomorrow, a team that includes billionaire investor Warren Buffett, ex-Commerce Secretary William Daley and former Federal Reserve Chairman Paul Volcker:

After the meeting in Chicago, Obama will hold his first press conference since winning the U.S. presidential election on Nov. 4, according to a statement from his transition team. Vice President-elect Joe Biden will also attend.

A pressing issue for the group is deciding on appointments for top economic jobs. Obama is looking to name a Treasury secretary nominee quickly as he confronts the financial meltdown and begins to craft his administration's response to the crisis.

Leading candidates for the Treasury post are Lawrence Summers, who ran the department under President Bill Clinton, and Timothy Geithner, president of the Federal Reserve Bank of New York, people close to the Obama camp have said. Another ex- Clinton Treasury chief, Robert Rubin, has taken himself out of the running.

Rubin and Summers are also on Obama's economic advisory team. Other members include Laura Tyson, who served as Clinton's top economic adviser; former Fed Vice Chairman Roger Ferguson; Time Warner Inc. Chairman Richard Parsons; former Securities and Exchange Commission chairman William Donaldson and Xerox Corp. Chief Executive Officer Anne Mulcahy.

I would include Paul Krugman and Jamie Dimon in that list but I think Larry Summers will likely step up to the plate. Summers understands "virulent deleveraging" and he will clean up the banks with a bazooka.

Speaking of virulent deleveraging, November 15th is the last day for hedge funds to receive notification from their investors for year-end redemptions. As U.S. pension funds start putting the brakes on hedge funds, keep an eye on the Japanese yen.

UBS says the yen will rise to 90 per dollar in a month. Deutsche Bank, the largest trader, sees that level reached this year, while Barclays' forecast is for six months. The banks are outliers on Wall Street, where the mean estimate for the yen is 99 at yearend, according to a Bloomberg survey. UBS expects the yen to rise to 119 per euro at year-end, from 125.99 today. Deutsche Bank forecasts 113 and Barclays predicts 120.

Carry trades grew during the past five years, driving the yen to 124.13 in June 2007, as central banks increased interest rates to fight inflation while Japan kept its key rate at 0.5 percent. Investors borrowing in the yen could sell the currency and profit by buying assets in Australia, where policy makers raised benchmark borrowing costs as high as 7.25 percent in March from 4.25 percent in 2002.

The strategy lost favor as the financial crisis caused banks and financial companies to report $693 billion of losses and writedowns since the start of 2007 and curbed demand for higher-yielding assets. Slowing economies also hurt the carry trade as central banks lowered interest rates to prompt growth. The Reserve Bank of Australia slashed its rate by 2 percentage points since Sept. 2, and the Bank of Japan cut its rate by 0.20 percentage point last week.

But with hedge funds slapping gates on jittery clients looking to redeem, the worst of the carry trade carnage may be over, for now.

Moreover, a new reflation trade may be in the offing as world central banks ease interest rates to historic low levels.

Beyond such short-term opportunities, Harrison believes the long-term price of things needed to " feed, power and educate the world" will remain in an upward path.

Such demand comes from emerging markets like China and India, and Harrison believes the long-term bullish thesis on emerging markets remains largely intact.

The one (big) caveat to the bull case to both commodities and emerging market assets is the potential for protectionism and isolationist policies to stall globalization's progress, he says. The dollar's continued strength (or weakness) will be a key tell, Harrison says, as he sees the markets heading for a "wishbone world" of either deflation or hyperinflation.

Indeed, the world is awash with liquidity but the only problem is that the cost of leverage has surged, hitting the hedgies right below the belt, and leaving many, including yours truly, to ask: are we bubbled out?

***

Important Disclaimer: Having said this, I am still praying for one FINAL bubble in alternative energy stocks, especially in the solar sector.

My buddy keeps telling me, "stay green and greedy". So far, I have turned green, purple and all shades in between. The old adage is so true: bears make money, bulls make money and pigs get slaughtered. Be nimble and take your profits in these markets or risk getting slaughtered.

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